What Are ESPP Shares and How Do They Work?
Discover how Employee Stock Purchase Plans (ESPPs) function as a valuable benefit, including their mechanics, financial considerations, and tax treatment.
Employee Stock Purchase Plans (ESPPs) offer employees a way to acquire company stock, often at a discount. These plans are a form of equity compensation, designed to align employee interests with the company’s performance. Participants purchase shares through regular payroll deductions.
Core Features of Employee Stock Purchase Plans
An Employee Stock Purchase Plan allows eligible employees to buy company stock at a discounted price, ranging from 5% to 15% off the market value. Employees contribute to these plans through payroll deductions, which accumulate over a specified timeframe. The Internal Revenue Service (IRS) limits the value of stock an employee can purchase through a qualified ESPP to $25,000 per calendar year, based on the fair market value at the offering date.
ESPPs operate within defined “offering periods,” during which employees can contribute funds for stock purchases. These periods can vary, often lasting between six months and two years. Within an offering period, there can be shorter “purchase periods” at the end of which shares are actually bought. For instance, a 12-month offering period might include two six-month purchase periods.
A common feature that can enhance the benefit of an ESPP is the “look-back provision.” This provision allows the purchase price to be calculated using the lower of the stock’s price at the beginning of the offering period or at the end of the purchase period, with the discount then applied to that lower price. This means employees can benefit even if the stock price increases during the offering period. Eligibility for ESPPs includes full-time employees, though individuals owning more than 5% of the company’s stock are excluded. Some plans require a minimum period of employment, such as one year.
How ESPP Shares Are Acquired
The process of acquiring ESPP shares begins with enrollment, where eligible employees sign up for the plan and designate a percentage of their payroll to be deducted. These deductions are made after-tax from each paycheck. The chosen percentage is then consistently withheld and accumulated by the company over the specified purchase period.
On the designated purchase date, which marks the end of a purchase period, the accumulated funds are used to buy company stock on the employee’s behalf. The purchase price is determined at this point, incorporating the plan’s discount and any applicable look-back provision. For example, if a plan offers a 15% discount and a look-back, the shares might be purchased at 85% of the lower price between the offering date and the purchase date.
After the shares are purchased, they are allocated and deposited into a designated brokerage account for the employee. This account allows the employee to view and manage their newly acquired shares.
Tax Treatment of ESPP Shares
The tax implications of Employee Stock Purchase Plans can be complex, primarily dependent on when the shares are sold relative to their purchase and offering dates. Income is not recognized at the time of purchase itself; instead, taxes are triggered when the shares are sold. However, the discount element, which is the difference between the fair market value and the discounted purchase price, is treated as ordinary income.
The two main types of dispositions, or sales, are qualifying and disqualifying dispositions, each with distinct tax treatments. A “qualifying disposition” occurs when shares are held for at least two years from the offering date and one year from the purchase date. In a qualifying disposition, the ordinary income component is calculated as the lesser of the discount at the offering date (e.g., 15% of the fair market value on the offering date) or the actual gain from the sale. Any additional gain beyond this ordinary income amount is taxed at the more favorable long-term capital gains rates.
Conversely, a “disqualifying disposition” happens if the shares are sold before meeting either of the qualifying disposition holding period requirements. For a disqualifying disposition, the ordinary income recognized is the difference between the fair market value of the stock on the purchase date and the actual purchase price. Any further gain or loss beyond this amount is treated as a capital gain or loss, which can be short-term or long-term depending on the holding period after purchase. Employers provide Form 3922, “Statement of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c).”
Selling and Holding ESPP Shares
Upon acquiring shares through an ESPP, employees face a decision: sell the shares immediately or hold them for a period. This choice directly impacts the tax consequences, as the timing of the sale determines whether it’s classified as a qualifying or disqualifying disposition. Selling shares promptly after purchase, a “quick sale,” allows participants to realize the immediate gain from the discount. This action results in a disqualifying disposition, meaning the entire discount is taxed as ordinary income.
Holding shares for the required periods leads to a qualifying disposition. This results in a portion of the gain being taxed at lower long-term capital gains rates. The decision to hold shares, however, introduces market risk, as the stock value could decrease during the holding period.
Accurate cost basis reporting is essential when selling ESPP shares, regardless of the disposition type. The cost basis used for calculating capital gains or losses needs to reflect the ordinary income component already recognized. Employers and brokerage firms provide tax documents like Form 1099-B and Form 3922.